What Qualifies a Property for a 1031 Exchange?
Smart investors multiply their wealth using the 1031 exchange.
The 1031 exchange is a tax-deferred exchange that is authorized by the Internal Revenue Service for investment properties. Exchange 1031 does not refer to the actual exchange of two properties between two owners, but to the process of selling one property and buying another. Section 1031 of the Internal Revenue Code governs these transactions; hence the mention of exchange 1031.
In a 1031 exchange, capital gains taxes on transferable property are deferred to a later date than they would normally be paid. A capital gain occurs when the selling price of an asset is higher than its original purchase price. Capital gains are subject to a minimum of 15% tax for individuals and 21% tax for corporations.
Advantages of the exchange according to the scheme 1031
The main advantage of a tax-deferred exchange is that the taxpayer can realize the property without incurring any immediate tax liability. This allows the taxpayer to retain the return on deferred tax dollars and at the same time swap assets.
Instead of selling investment property, paying capital gains tax, and then using the net proceeds to buy other property, 1031 Exchange rules allow the investor to waive paying capital gains tax and use all proceeds from the sale to invest in new property, thus the tax capital gains are deferred until the sale of the new property.
For example, John, who personally owns $10 million investment property in New York City, wants to sell his property and buy another. Without the option to use the 1031 tax-deferred swap, John would have to pay approximately $2.34 million in capital gains taxes to the government, which reduces the amount he can reinvest in replacement properties to $7.66 million. For simplicity, I don’t I take into account the costs of closing the transaction when entering and exiting the investment. These expenses can be deducted from capital gains to get true capital gains tax.
However, following the 2000-37 IRC income procedure, John purchases a replacement property and transfers the tax base of the old property to the new property. He will be able to avoid the $2.34 million tax and defer it until the replacement property is sold, usually many years later. Reinvesting pre-tax dollars in other real estate through the 1031 tax exchange has a lot of value, and most sophisticated real estate investors know that this is one of the fastest ways to build wealth.
The hidden profit will eventually be made when the replacement property is sold, although this is not always the case if the property is inherited, as the investor’s heirs receive an increased base on such inherited property. Upon the death of an investor, his or her heirs will receive the property at fair market value at the date of transfer to the heirs, and not at the basis transferred to the replacement property since the original purchase.
When the heir is about to sell the property, he will pay tax on the difference between the new sale price and the fair market value of the property at the time of the inheritance. In addition, another benefit of the 1031 exchange is that the investment property can eventually be converted to a primary residence if done after 2 years of ownership in accordance with safe harbor rules.
Please note that for the 1031 transaction to be effective, ownership of the replacement property must be registered using the same tax identification number as the property sold.
1031 Exchange rules require both properties to be “similar”. According to the rules, the exchange of residential investment property for residential investment property, commercial investment property for commercial investment property, residential investment property for commercial investment property and vice versa is considered an exchange in kind.
However, the property must be located in the United States, as the exchange of American property for foreign property is not considered “similar” under the rules.
The 1031 exchange requires the participation of a qualified intermediary, as defined in section 1031 of the Internal Revenue Code, to carry out the entire process.
All proceeds from the sale, including non-cash proceeds (such as a car that you may receive in exchange for real estate), must be sent to a qualified intermediary to be used to purchase a new property. Anything directly or indirectly received by the seller (no matter how insignificant) will disqualify the entire transaction, resulting in the recognition of all income (and in the case of a foreign buyer, withholding). FIRPTA retention).
1031 Exchange Timeline
Very specific rules regarding identification and expiration dates.
The new property must be located in the United States.
From the closing date of the old property, the seller has 45 days to provide a qualified intermediary with a list of the properties he wants to buy (this list is called the “45-day list” and it usually contains several properties in case the transaction falls through ). From the closing date of the old property, the seller has 180 calendar days to purchase one or more properties from the “45-day list”;
The seller of the old property must take ownership of the new property in the same legal name in which he owned the old property.
The seller is obliged to buy new property for an amount equal to or greater than the sale price of the old property.
The proceeds from the sale of the old property, after payment of closing costs and liabilities, must go to a qualified intermediary and be used to purchase the new property.
The 45-day deadline must be strictly adhered to, as it cannot be extended, even if the 45th day falls on a Saturday, Sunday, or US legal holiday.
The exchange period ends exactly 180 days after the date of transfer of the transferable property or the filing date of the tax return for the taxable year in which the transfer of the transferable property occurred, whichever comes first. Again, the 180-day deadline must be strictly adhered to as it is non-renewable, even if the 180th day falls on a Saturday, Sunday, or US legal holiday.
Realized vs Recognized Gain in 1031 Exchange